It also explains why the fiscal multiplier is low.

In comments here on the problem with Quantitative Easing, Auburn Parks said:

The real problem with QE is that it doesn't add any Govt liabilities for the private sector to hold as wealth.

I quoted that back to him and replied:

So you are saying that the real problem with the economy is that there is not enough financial wealth for the private sector to hold? You would have to convince me.

Geerussell said:

This is a great excuse to roll out this old chart from way back.

He linked to this graph:

Graph #1: Dollars of Private Debt for each Dollar of Federal Debt (black line, right scale)

The graph shows a measure of private debt (red), a measure of Federal debt (green), their sum (blue), and their ratio (black). The black line shows that, for every dollar of Federal debt, there was from four to six dollars of private debt (reading the right-side scale). Then, in the mid-1990s it went to eight dollars of private debt, and in the 2000s it went briefly to nine dollars of private debt for every dollar of Federal debt.

Geerussell writes,

There are two ways to reduce the burden of debt. Reduce [private] debt, or increase the equity on which it rests. I'd say there's a pressing need to pursue both avenues.

Geerussell's point is that if the high level of private debt relative to Federal debt is a problem, then we can solve that problem either by reducing private debt or by increasing Federal debt. Or both.

I can't argue with that arithmetic. But I look at things differently. If the high level of private debt relative to Federal debt is a problem, I want to understand why the ratio is so high. I ask: Why is private debt so high? and Why is Federal debt so low?

Funny, isn't it? Federal debt is NOT low. It is only low relative to private debt, because private debt is so massively big. Anyway, apparently both Geerussell and Austin Parks would be happy to see the Federal debt increase. I'd rather see private debt decline.

Why is private debt so high? If we don't answer that question, private debt could stay high despite a significant increase in Federal debt. I mean, if we grow the Federal debt on purpose to make the black line fall, private debt might increase faster also, so that the black line does not fall. If the black line does not fall, the ratio remains high.


Here is an updated version of the previous graph:

Graph #2: An Updated, Longer-Term version of the Black Line on Graph #1

Graph #2 goes back two decades further into the past than #1. It also uses improved measures of public and private debt. So the high values achieved on Graph #1 are only about half as high on #2: four instead of eight in 2001, 4½ instead of 9 in 2008. But the two graphs show the same pattern.

Economic growth in the 1950s and '60s was generally good, supported by strong and persistent growth of debt -- as you can see from the strong uptrend on the graph during those decades. There was a little hesitation in 1967 and again during the 1970 recession, as the ratio reached  2.5-to-1 and 3-to-1. Then, from the 1974 recession to the early 1990s the ratio ran flat or trended slightly down. Economic performance was not impressive in those years, because debt and financial costs had already reached a high level.

Eventually the ratio fell a bit, and by the mid-1990s started climbing again. And the economy was good again, while the ratio climbed. But climbing pushes the ratio higher; financial costs take more of a bite out of profits and aggregate demand; and the economy slows again.

Finally, the burden of debt broke the economy, we had the crisis and "great recession", and the ratio started falling. It is lower now than it was at the onset of the 1990s boom, and that is promising. But at $2.5 dollars of private debt per dollar of gross Federal debt, the ratio is still high today.

It was increase in the private debt ratio that made vigorous growth possible; we see this 1950-1970, we see it 1994-2000, and we could see it again soon.

Increases in private debt make the economy vigorous. But the increases push the ratio up, making further increase less likely. And when the ratio runs high, the economy runs into trouble. We need the ratio low in order to attain a sustained period of economic vigor.


Is increased government participation the solution to the problem? Well... Was there a fall in government participation that caused the problem?

No. Government participation did not fall:

Graph #3: Debt in Billions -- Total Private Debt (red) and Gross Federal Debt (blue)

The high ratio could have been caused by the fall of government participation, or by the rise of private participation. But government participation did not fall. It grew. So the high ratio was not caused by the fall of government participation. So it must have been caused by the rise of private participation.

We use credit for growth; therein lies the problem.



I worried above, that

if we grow the Federal debt on purpose to make the black line fall, private debt might increase faster also, so that the black line does not fall. If the black line does not fall, the problem remains.

That is in fact what we see between 1971 and 1991 on Graph #1. The black line wanders along a horizontal trend path. This means that private debt was increasing at about the same rate as the Federal debt.

You can see it on Graph #2 also: the red line runs roughly flat from 1970 to 1990. So if it is true that the Federal government increased spending and deficits in an attempt to restore economic vigor to our flagging economy, then it must be true that private debt increased more rapidly also -- at about the same rate as the Federal increase.

Graph #4 shows the Gross Federal Debt as given in FRED's FYGFD series. That's the blue line. The red line is an exponential trend line generated by Excel for the years 1945 to 1974:

Graph #4: Gross Federal Debt (blue) and the Golden Age Trend (red)

The red line is an exponential curve based on the Federal debt of the Golden Age. Think of it as showing what the Federal debt would have been if we did not grow the Federal debt on purpose to restore economic vigor.

Think of the gap between the red and blue lines as extra debt accumulated in the process of trying to drive the private/public debt ratio down. Trillions and trillions and trillions of dollars.

Did all that extra Federal debt push down the ratio on Graphs #1 and #2? No, it did not. We know that private debt and Federal debt grew at about the same rate for near 20 years, from 1970 to 1990 or so. Twenty years of unimpressive economic growth. The boost to Federal spending created an inadequate boost for the economy because private debt remained high.

If your plan is to fix the economy by expanding government spending, well, your plan has already been tried. It didn't work.

Why didn't it work? To be blunt, it didn't work because we didn't have a Depression in those years. A Depression would have wiped out a lot of private debt while the government spending was pumping money into the economy. That didn't happen.

Instead, the private sector took every new dollar of government money and diced it up into many more dollars of private lending and debt. Instead of falling, private debt increased.


Why is private debt so high? Because we have many policies that encourage the use of credit, and no policy that encourages repayment of debt.

Increasing Federal spending and Federal deficits will not restore vigor unless policies are put in place to limit the expansion of private debt -- for example, by tax incentives for accelerated repayment.


Related posts:

Debt Relatives: The Cousins

FRED: Federal spending as a % of GDP (blue) and Federal deficits as a % of Federal spending (red)

More cowbell